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Why investors shouldn't panic over the yield curve inversion

Emma Rapaport  |  27 Mar 2019Text size  Decrease  Increase  |  
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The yield curve – a leading economic indicator that has accurately predicted the past five US recessions - inverted Friday fuelling fears of a global economic downturn.

Weaker-than-expected US factory activity in March, along with similarly dour reports from Europe and Japan, helped send US Treasury yields into an inversion, with the spread between yields of three-month Treasury bills exceeding those of 10-year notes for the first time since 2007.

Come Monday, Wall Street stocks sold off sharply, with all three major US stock indexes posting their biggest one-day percentage declines since 3 January.

Economic slowdown fears spread to global markets. Locally, the ASX recorded its worst session in 12 weeks on Monday.

The yield curve inversion, if it holds, is seen by some as an indicator that a recession is likely in one to two years.

But not everyone agrees this dark omen signals recession this time round.
We sat down with Morningstar head of multi-asset portfolio management, Brad Bugg, to find out why he thinks fears of an imminent recession are misplaced and to discuss how Australian investors can fortify their portfolios during a period of slowing global growth.

Q. What is the yield curve?

Bugg: The yield curve represents the different interest rates investors will receive for differing matures in differing government securities – typically bonds.

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In a normal environment, you'd expect short maturities to get an interest rate, and longer maturities to get a higher interest rate. Essentially, you're being compensated for investing your money for longer periods of time.

Q. Why is the curve inverting?

Bugg: Typically, a yield curve will invert where the risks in the shorter term are perceived to be greater than in the longer term. People see greater risks in the short term but realise over the longer term that a lot of that will wash out and things will go back to normal.
One of the biggest short-term concerns is that global growth is starting to slow, and with slower growth, that potentially brings higher risks in the form of company revenues or sales being lower than expected - whereas people still see the medium to long term outlook for growth being pretty reasonable because the emerging markets around the world will continue to grow.

Q. Is the yield curve a good predictor of recessions?

Bugg: There have been instances historically where an inverted yield curve, when it has remained inverted for a period of time, has pointed to a recession. It doesn't always work, but it’s been a reasonable indicator in the past.

Historial 10Y-1Y spread on treasury yield
yield curve

Source: GuruFocus.com

Q. Does this month’s inversion signal a recession?

Bugg: Despite all the doom and gloom in markets, global growth still remains reasonable. The expectation is that we'll have growth of above 3 per cent for the next couple of years. But if you look at individual countries that outlook can be quite diverse.

China, for instance. While everyone is expecting slower growth, that economy will still probably grow at above 6 per cent. Whereas if you look at some parts of Europe, growth may be a lot lower, below 1 per cent. But I think what everyone is watching at the moment is the US. More recently we've been growing at about 3 per cent, but this could slow to about 2 per cent. It's not necessarily a recession, but it's definitely a weaker environment than what we've been in.

Q. How can Australian investors prepare their portfolios for the slowdown?

Bugg: An Australian investor who is investing in bonds and equities will probably need to be a little bit more cautious given that we are seeing indications of slower growth and a difficult period ahead. Typically, lower interest rates would reflect that environment, but if you look at interest rates today, being at their all-time low (1.5 per cent, with two rate drop tipped for later this year), that would suggest that a bad outcome or environment is already priced into markets. People might like to take advantage of that and invest in shorter-dated securities – they could be getting paid a reasonable interest rate but not having to lock their money up for longer periods of time. At the moment, the 10-year bond rate is 1.75 per cent whereas the cash rate is 1.5 per cent, so to get that extra 25 basis points, you're having to lock your money up for long period of time. Why not just be a little bit more cautious, take the 1.5 per cent (or whatever you can get) for a shorter period?

Q. Are there any sectors of the market where you're seeing elevated risk in this environment, and are there any sectors you favour?

Bugg: A few Australian miners have had a particularly strong run off the back of high commodity prices, which have been buoyed by stronger growth. So, if we're entering an environment where growth is going to be lower, that will probably point to lower commodity prices, which is not good for miners.

The financial sector. Lenders typically make their margin by borrowing or lending long term – for 25 years on mortgagees, for instance. But with a flatter yield curve, that affects their margin. That's a less favourable environment for them.

The sectors we do favour at the current time are typically more defensive sectors – telecommunications and infrastructure, for instance.

Real estate investment trusts are expensive. REITs have done well because they offer a higher yield, and with the typically yielding securities like cash and bonds falling a long way, people have fallen into those REIT structures to get that higher interest rate. So, we think that's pretty priced in at the moment.

is the editorial manager for Morningstar Australia. Connect with Emma on Twitter @rap_reports. You can email Morningstar's editorial team editorialAU[at]morningstar[dot]com

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